Oil in the Spotlight

While oil prices have come down since their recent peak a few weeks ago, they remain in the spotlight.  This weekend, President Obama used his Saturday address to call for increasing drilling.  Coming on the heels of last week's grilling by the Senate Finance committee of the nation's top oil executives a propos of a proposal to end longstanding tax breaks for drilling, his remarks capture the frustration many people feel about rising gasoline prices.

Our anger would no doubt bemuse many overseas for US gas prices are low by global standards.  Indeed, as the attached graph shows, they are still less than those registered two years ago.  What is nonetheless frustrating about gas prices is their volatility.  Gas price shocks like hurricanes and flooding are hard to predict but when they occur,devastating.  The impact of the 1970s shocks are well understood: they launched stagflation in the US and Europe and inaugurated a huge transfer of wealth to the oil states that persists to this day.  But even the milder 2008 shock, some economists now believe, may have played a role in triggering the Great Recession.  And the story that many are using to explain the collapse, not just in oil prices but in commodity prices across the board in recent weeks, is expectations of a weak economy ahead--perhaps one deflated by high commodity prices over the last year.

As frustrating as oil shocks are, the record of efforts to address them has been more frustrating still. The 1970s oil shocks were bad but the famous lines at the pump that helped Ronald Reagan defeat Jimmy Carter were due not to the oil shocks but to price controls--a policy intervention that succeded only in creating shortages.  Worse, price controls were slapped on domestic oil but not foreign oil, and traders reaped millions by illegally recertifying shipments. 

In 1980, Congress passed a windfall profits tax on oil.  Given the huge profits by oil companies at the time, it seemed like sound economic policy  However, the tax applied only to domestically produced oil and, in retrospect, was a key step in accelerating our dependence on foreign oil.  More successful was the creation of the Strategic Petroleum Reserve and the creation of gas mileage standards. But neither of these has proved a silver bullet either.  The Reserve has yet to be tapped and the CAFE standards, while they have cut fuel use, by looking at the entire fleet are correctly criticized for allowing gas guzzlers to persist.

If controlling volatility in commodities markets has never been easy, it has become more difficult in recent years.  A series of commodity index funds launched by Merril Lynch but now owned by Goldman Sachs have become established vehicles for hedge funds and others to place large quantities of money, exacerbating movements.  Indeed one theory of the commodiites runup this past year is that it reflects global liquidity created by the QE2 program of the Fed that spent about $600 billion buying securities.   Indeed, the commodities crash last week, coincided with the end of QE2.  Yet another theory for the commodities crash is that authorities raised margin requirements on commodities traders.  The commodities "bubble" as some has described it has drawn comparisons with the financial and real estate bubbles, in particularly, in light of the IPO "at the top" scheduled this week by Glencore, the company started by Marc Rich decades ago after he fled the United States.

All of this is a way of saying that reining in oil and gasoline prices is not easy.  But given the devastation, price spikes can cause, it must still be attempted.  Perhaps the single most important thing we ought to do is reign in Opec, the organization that more than any other can alter the price of oil.  Secondly, financial regulators need to study more carefully how trading in commodity indices as an asset class can drive monetary movements with serious real world consequences.  Beyond that, we should be working over the long term to wean ourselves off scarce resourcs such as oil toward renewable resources.  That cannot happen overnight but it will be the only long term resolution to the problem of oil and gasoline price volatility.